Question Paper
Management of Financial Institutions – I (321) – July 2005 Section A : Basic Concepts (30 Marks) • This section consists of questions with serial number 1 - 30. • Answer all questions. • Each question carries one mark. • Maximum time for answering Section A is 30 Minutes. 1.
Which of the following is considered as approved securities for the computation of statutory liquidity ratio? (a) (b) (c) (d) (e)
2.
Indira Vikas Patra Kisan Vikas Patra National Thermal Power Corporation Bonds Water Supply Sewerage Bonds Mahanagar Telephone Nigam Ltd. (MTNL) Bonds.
Janata Bank Ltd. decides to give its shareholders a return of 18%. The bank’s total assets consists of Rs.2,400 crore of which the debt and equity portions are Rs.2,000 crore and Rs.400 crore respectively. Assuming that all assets are loans, the profit margin to be set by the bank in order to pay the proposed return is (a) 18%
3.
(b) 15%
(d) 0.36%
< Answer >
(e) 0.30%. < Answer >
(b) Typhoon, cyclone, flood (d) Riots and strikes
If the master or crew of the ship fraudulently deviates or sells the cargo, then this risk is called as (a) Jettison (d) Dacoity
5.
(c) 1.8%
Which of the following perils is covered in fire insurance policy? (a) Earthquake (c) Lightning (e) War risks.
4.
< Answer >
(b) Piracy (e) Expropriation.
< Answer >
(c) Barrating
Under social security scheme of the Central Government, the IRDP beneficiaries are covered under group insurance for which there is no payment of premium.
< Answer >
The amount payable on death due to natural cause of the borrower is (a) Rs.5,000 (b) Rs.15,000 (c) Rs.25,000 (d) Rs.50,000 (e) Rs.75,000. 6.
If the mortgagor creates a mortgage in favour of the creditor by registering the deed of mortgage with the Registrar of Assurances, then it is known as (a) English mortgage (c) Simple mortgage (e) Usufructory mortgage.
7.
8.
< Answer >
CDs are not freely negotiable CDs are subject to payment of stamp duty CDs are long-term borrowings CDs are issued by scheduled banks including RRBs and cooperative banks CDs are considered as part of net demand and time liabilities for computation of CRR.
Which of the following is false with regard to commercial paper? (a) (b) (c) (d) (e)
9.
(b) Equitable mortgage (d) Anomalous mortgage
Which of the following is true with regard to certificates of deposits? (a) (b) (c) (d) (e)
< Answer >
< Answer >
Commercial papers are issued subject to a minimum of Rs.5 lacs and its multiples CPs are short term borrowings by banks The maturity period of CPs is 15 days to one year CPs are negotiable by endorsement CPs are unsecured.
A portfolio manager who wants to resort to riding the yield curve for making capital gains assumes 1
< Answer >
I. II. III. IV.
Yield curve should be upward sloping. Yield curve should be downward sloping. There must be upward shift in interest rates. There must be downward shift in interest rates.
(a) Only (I) above (c) Both (I) and (III) above (e) Only (III) above.
(b) Both (II) and (III) above (d) Both (I) and (IV) above
10. If nominal interest rate is 8% expected inflation is 4% and the relevant marginal tax rate is 25% then (a) (b) (c) (d) (e) 11.
The real rate of interest is 6% The after tax real rate of interest is 2.25% The real rate of interest is 2% The after tax real rate of interest is 2% The real rate of interest is 3%.
What is the credit conversion factor for a forward rate agreement (FRA) with remaining maturity not exceeding three years? (a)
0.5%
(b) 1.0%
(c) 1.5%
(d) 2.0%
I. II. III. IV.
The asked price is always higher than the bid price. The bid yield is always higher than the asked yield. If yields have risen since a bond was issued, it will sell at a discount from the face value. If yields have fallen since a bond was issued it will sell at a discount from the face value.
(a) (b) (c) (d) (e)
(I), (II) and (III) above (II), (III) and (IV) above Only (IV) above Both (I) and (IV) above Both (II) and (IV) above.
13. When the interest rate is below the equilibrium interest rate, there is an excess ______ for (of) bonds and the interest rate will _________.
< Answer >
< Answer >
Supply; fall Supply, rise Demand; rise Demand; fall Demand; rise and then fall.
14. Janata bank has written off some loans as bad loans. Its (a) (b) (c) (d) (e)
< Answer >
(e) 2.5%.
12. Which of the following is true regarding coupon paying bonds?
(a) (b) (c) (d) (e)
< Answer >
< Answer >
Total assets and total liabilities decrease by that amount Total liabilities and capital decrease by that amount Total assets, total liabilities and capital decrease by that amount Total assets and capital decrease by that amount Total liabilities and capital increase by that amount.
15. How does an increase in the money supply affect the exchange rate?
< Answer >
(a)
Since interest rates increase, foreign citizens will be less likely to want to buy Indian financial assets and the rupee depreciates (b) Since interest rates increase, foreign citizen will be more likely to want to buy Indian financial assets and the rupee appreciates (c) Since interest rates decrease, foreign citizens will be less likely to want to buy Indian financial assets and the rupee depreciates (d) Since interest rates decrease, foreign citizens will be more likely to want to buy Indian financial assets and the rupee appreciates (e) Monetary policy does not change the exchange rate. 16. X bank has a portfolio of Rs.7000 crore under investments. The bank has provided a sum of Rs.300 crore towards depreciation, whereas the actual requirement is Rs.260 crore. This excess provisioning can be reflected in the balance sheet as (a) Rs.6740 under investment and Rs.40 crore to Investment Fluctuation Reserves (b) Rs.6700 under investment and Rs.40 crore to Investment Fluctuation Reserves 2
< Answer >
(c) Rs.6960 under investment and Rs.260 crore to Investment Fluctuation Reserves (d) Rs.6960 under investment and Rs.300 crore to Investment Fluctuation Reserves (e) Rs.7000 under investment and Rs.300 crore to investment Fluctuation Reserves. < Answer >
17. Government spending can crowd out investment in the long run because (a) If the government is spending more, investors must spend less (b) Output expansion causes wages and prices to rise, which increases money demand and thus interest rates (c) Output expansion causes wages and prices to fall, which increases money demand and thus interest rates (d) Output expansion causes increases the value of the rupee which increases foreign investment (e) Output expansion decreases the value of the rupee, which increases foreign investment. 18. If the interest rates decrease, the ____ in the interest income is ____ than the ____ interest expenditure when the maturity gap is _______. (a) (b) (c) (d) (e)
< Answer >
Decrease, less, increase, negative Increase, more, decrease, positive Decrease, less, decrease, negative Decrease, more, increase, positive Increase, less, increase, positive. < Answer >
19. Which of the following statements is false? (a)
When duration gap is positive, if interest rates increase, the changes in the market value of assets decreases more than the changes in the market value of liabilities (b) When duration gap is positive, if interest rates decrease, the market value of equity increases (c) When duration gap is positive, if interest rates increase, the market value of equity decreases (d) When duration gap is negative, if interest rates decrease the market value of equity increases (e) When duration gap is zero, if interest rates increase, the decrease in the market value of assets is equal to the decrease in the market value of liabilities. 20. The current market price of a 91-day T-Bill is Rs.98.30 and a 182-day T-Bill is Rs.96.80. An investor buys and holds the 182-day T-Bill and plans to sell this after 91 days. Assuming that there will be no change in the yield curve in the intermittent period, what will be the investor’s expected return per annum? (a) 6.11%
(b) 6.22%
(c) 6.33%
(d) 6.92%
< Answer >
(e) 6.94%.
21. Which of the following is/are true with respect to valuation of permanent investments by banks?
< Answer >
(a) Permanent investments should be valued at cost (b) In case the cost price is higher than the face value, the difference should be ignored and should not be amortized or taken to income account (c) In case the cost price is lower than the face value, the difference should be amortized over the remaining period of maturity of the security (d) Permanent investments should be valued at average market price (e) Permanent investments should be valued at average market price plus 10%. 22. The total assets of Swastik Bank are Rs.750 crore of which 6% are NPAs. The return on assets is 8%. If the corporate tax rate applicable to the bank is 25% the ENPA level of the bank is (a) 110.33%
(b) 122.22%
(c) 133.33%
(d) 177.78%
(e) 222.50%. < Answer >
23. Semi-implicit pricing strategy of banks refers to (a) (b) (c) (d) (e)
< Answer >
No interest on current accounts, no check charges The bank makes charges but rebates on the basis of balance Paying interest as a function of average balance Charge as the costs go up and competition permits Very low interest on current accounts, pricing below cost.
24. Fortune Bank charges 14% for consumer loans given to its customers. Capital adequacy is required to be maintained at 15%. What should be the capital charge adjusted return on the loan, if the required return on capital is 12%? (a) 16.8%
(b) 15.8%
(c) 13.2%
(d) 12.2%
(e) 17%.
25. If a 91-day T-bill of face value Rs.100 is acquired in the auction at a yield of 4.25%, then the purchase price is 3
< Answer >
< Answer >
(a) Rs.95.75
(b) Rs.96.25
(c) Rs.97.45
(d) Rs.98.35
(e) Rs.98.95.
26. An arrangement where the bank financing the infrastructure projects, enter into a prior agreement with the Infrastructure Development Finance Corporation for transferring their outstanding in respect of such financing to the latter on a predetermined basis is known as (a) Take out financing (c) Narrow banking (e) Syndicated credit.
(b) Cash flow financing (d) Securitization < Answer >
27. Consider the following data of a private sector bank Liabilities to others Asset with the banking system : Liabilities to the banking system
< Answer >
: Rs.4,500 crores Rs. 800 crores : Rs. 400 crores
The NDTL of the bank is (a) Rs.4,500 crores (c) Rs.4,100 crores (e) Rs.5,700 crores.
(b) Rs.4,900 crores (d) Rs.5,300 crores < Answer >
28. Efficiency ratio is defined as (a) (b) (c) (d) (e)
Non-Interest Expenses/Net Total income Non-Interest Income/Non-Interest Expenses Interest Earned/Credit Interest Income/Total Income Total Income/Total Assets.
29. Marketing management is accepted as the efficient management of four P’s in respect of manufacturing concerns and units dealing in tangibles. Which of the following is an additional P’ for service sector like banking? (a) Price
(b) Process
(c) Place
(d) Product
< Answer >
(e) Promotion. < Answer >
30. Which of the following statements is false? (a)
Property-liability insurance is offered based on the pooling of many similar risks of known probability (b) Probability of loss is not known in non-actuarial type of risk (c) For non-actuarial risks, the financial system offers external insurance (d) Property-liability insurance, life insurance policies are designed to cover actuarial risks (e) Property-liability insurers take on many unrelated risks, each risk is small relative to their capital. END OF SECTION A
4
Section B : Problems (50 Marks) This section consists of questions with serial number 1 – 5. Answer all questions. Marks are indicated against each question. Detailed workings should form part of your answer. Do not spend more than 110 - 120 minutes on Section B. 1.
The balance sheet of a private sector bank as on March 31, 2005 is as follows: (Rs. In crore) Liabilities
Amount
Capital
50
Reserves & Surplus Deposits
1,500 18,700
Assets
Amount
Cash and balance with RBI
1,500
Balance with banks and money at call & short notice
1,400
Investments
8,400 9,300
Borrowings
300
Advances
Other Liabilities and Provisions
650
Fixed Assets
200
Other Assets
400
21,200
21,200
The interest rate profile for different assets and liabilities is as follows: Assets
Composition %
Rate %
Balance with banks and money at
60
0
call & short notice
40
4.0
Investments :
SLR
75
6.0
Others
25
8.0
Agriculture
15
PLR
Export Credit
5
PLR–1
SSI
20
PLR+1
Housing
25
PLR+2
Others
35
PLR+3
Savings Bank Deposits
20
3.5
Demand Deposits
12
–
Term Deposits
18
5.0
20
5.5
30
6.0
60
7.0
40
8.0
Advances:
Liabilities
Borrowings :
The Top Management Team of the bank proposes to raise a subordinate debt of Rs.450 cr. to strengthen the capital base and to deploy this amount entirely in export credit. The present prime lending rate of the bank is 9%. You are required to a.
Compute the maximum interest rate the bank can pay for the subordinate debt to maintain its existing spread. 5
b.
What will be the NII after the deployment of Rs.450 crore?
c.
Assuming that the PLR in question is one year PLR and the two year PLR is 10%, what will be the implicit forward rate for one year, one year hence using the expectations theory?
d.
Is there any logical fallacy in your answer as computed in (c) and if yes what is the reason for it? (6 + 2 + 2 + 2 = 12 marks) < Answer >
2.
The NDTL of a bank on a reporting Friday is computed as Rs.18,800 crore. The owned fund position of the bank during the fortnight is given as follows: Rs. in crore
1 – 6 days
550
7 – 11 days
600
Rest of the days
500
Assume that CRR is at 5% and minimum CRR to be maintained on daily basis
is at 70%. You are required to: a.
Suggest a borrowing schedule for the bank so that the interest cost is at minimum and justify your suggestion.
b.
Compute the interest outgo if the short term borrowing rate for different intervals during the fortnight turned out as follows:
1st – 7th day
:
4.00%
8th – 12th day
:
5.00%
:
6.00%
th
th
13 – 14 day
(7 + 1 = 8 marks) < Answer > 3.
The following is the balance sheet of Janata Bank Ltd. as on 31.03.2005: Liabilities
Duration in years
Amount Rs.
Interest rate %
Assets
Duration in years
Amount Rs. in Cr.
Interest rate %
Cash and Balance with RBI
–
1200
–
Balances with banks
–
200
–
in Cr. Capital and Reserves
1100
Deposits: Demand
0.5
3800
3.5
InvestmentsShort term
1.0
2400
6
Term Deposits
1.0
3300
5.00
- Long term
3.5
4500
8
Term Deposits
2.0
4200
5.50
Secured Loans
3.0
5400
10
Term Deposits
3.0
4800
6.00
Borrowings
0.25
800
7.00
Unsecured Loans
1.0
4300
12
18000
18000
The bank forecasts a 1% increase in the interest rate You are required to a.
Compute the duration of assets and liabilities 6
b.
Compute the duration of surplus
c.
Assess the impact of change in the interest rate on the market value of assets, liabilities and the equity
d.
Immunize the market value of the firm using the Immunizing Asset Duration method. (2 + 2 + 4 + 4 = 12 marks) < Answer >
4.
The following is the balance sheet of Fortune Bank Ltd. as on March 31, 2005: Rs. in crore Liabilities Capital Reserves & surplus Deposits - Demand Deposits - Savings Bank Deposits - Term Deposits Borrowings Other liabilities and provisions
Amount 300 275 1125 1875 5150 375 750
Assets Cash on hand Balances with RBI Balance with Banks: - in current accounts - in other accounts Money at call and short notice Investments – SLR - Others Advances Fixed assets Other assets
Amount 90 430
90 80 110 2150 750 5375 325 450 9850 9850 The bank has received a proposal of Rs.200 cr. for working capital limits from an export oriented unit (EOU). a.
Do you think the bank should finance the loan proposal? If yes, how?
b.
Compute the average cash balance maintained by the bank using the consolidated working funds approach.
c.
Compute the tolerance limits for the average cash balance, if 5% variance is acceptable
d.
Compute the Cash balance that is to be maintained, if the bank expects a rise of 10% in its deposit level. (2 + 2 + 2 + 2 = 8 marks) < Answer >
5.
A private sector bank has its branch in Hyderabad. The following information in respect of the branch for the year ending March 2005 is extracted from the general ledger: Deposits Saving Bank Deposits Demand Deposits Term Deposits One Year Two Years Three years and above NRE Deposits FCNR Deposits Advances Cash credit Staff loans Export credit Consumer loans Housing loans Gold loans Other details
7
Rs. inlacs
Interest
2,780 1,160
3.5% --
1,880 1,220 3,450 4,270 2,250
4.5% 5.0% 5.5% 4.0% 6625000
3,650 240 5,450 1,590 4,170 2,525
11% 8% 7.5% 13% 8% 22050000
Rent and taxes Telephone Electricity Depreciation Repairs Stationary and printing Traveling expenses Medical expenses Miscellaneous expenses Salaries Drafts issued TTs issued Travelers cheques issued Cheques for collection Bills for collection
Rs. in lacs 77 9 14 40 5 62 28 32 42 128 6,960 11,080 18 1,040 2,060
Additional information:
The branch accountant has the following information to share with you: 1.
The postage account in the general ledger shows a credit balance of Rs.90,000
2.
The income on account of the miscellaneous business generated amounts to 0.10% of the business and an additional amount of Rs.4,80,000 has also been received on account of some miscellaneous business transactions.
3.
The transfer pricing mechanism of the bank applicable to the branch considers the following:
The branch will receive 108% of the interest paid on deposits from the head office plus an additional amount of Rs.21.50 lacs for the year.
The branch will pay 25% less than the actual interest received on advances to the head office and an additional amount of Rs.6.90 lacs on account of miscellaneous liabilities like excess cash held.
You are required to arrive at the operating result of the branch for the year. (10 marks) < Answer >
END OF SECTION B
Section C : Applied Theory (20 Marks) This section consists of questions with serial number 6 - 7. Answer all questions. Marks are indicated against each question. Do not spend more than 25 -30 minutes on section C.
6.
Securitization is a concept that has been around for sometime but has only recently been taken up as a technique that could apply to a wide range of financial assets. What is securitization? Explain the benefits and potential pitfalls of securitization. (10 marks) < Answer >
7.
Mere identification of the presence of the interest rate risk will not suffice. A system that quantifies the risk and manages the same should be put in place so that timely action can be taken. Discuss the various approaches adopted to quantify interest rate risks. (10 marks) < Answer >
END OF SECTION C 8
END OF QUESTION PAPER
Suggested Answers
Management of Financial Institutions – I (321) – July 2005 Section A : Basic Concepts 1.
Answer : (d) Reason :Water Supply Sewerage Bonds are considered as approved securities for the computation of statutory liquidity ratio
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2.
Answer : Reason :Profit (PAT) = Re × Equity = 0.18 × 400 = Rs.7.2 crore Profit Margin = 7.2 / 2400 = 0.3%.
(e)
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3.
Answer : Reason :Lighting is covered in fire insurance policy.
(c)
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4.
Answer : (c) Reason :If the master of crew of the ship fraudulently deviates or sells the cargo, then this risk is called as barrating.
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5.
Answer :
(a)
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6.
Answer : (c) Reason :If the mortgagor creates a mortgage in favour of the creditor by registering the deed of mortgage with the Registrar of Assurances, then it is known as simple mortgage.
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7.
Answer : (b) Reason :CDs are subject to payment of stamp duty is true with regard to certificates of deposits
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8.
Answer : (b) Reason :CPs are short term borrowings by banks is false with regard to commercial paper.
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9.
Answer : (c) Reason :A portfolio manager who wants to resort to riding the yield curve for making capital gains assumes that Yield curve should be upward sloping and there must be upward shift in interest rates.
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10 Answer : (d) . Reason :If nominal interest rate is 8% expected inflation is 4% and the relevant marginal tax rate is 25% then the after tax real rate of interest is 2%.
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11. Answer : (d) Reason :Credit conversion factor for FRAs with maturity between 1 year and 2 year is 1.0%. For each additional year 1.0% to be added. So in this case
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Reason : The amount payable on death due to natural cause of the borrower is Rs.5,000.
9
conversion factor is 2.0%. 12 Answer : (a) . Reason :The asked price is always higher than the bid price, the bid yield is always higher than the asked yield and if yields have risen since a bond was issued, it will sell at a discount from the face value are true regarding coupon paying bonds
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13 Answer : (b) . Reason :When the interest rate is below the equilibrium interest rate, there is an excess supply for (of) bonds and the interest rate will rise.
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14 Answer : (d) . Reason :Janata bank has written off some loans as bad. Its total assets and capital decrease by that amount.
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15 Answer : (c) . Reason :An increase in the money supply decreases interest rates. This makes Indian bonds and other financial assets less attractive, the demand fore rupee decreases and the rupee depreciates.
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16 Answer : (a) . Reason :Amount to be shown in the assets side of balance sheet = Gross investment – Actual depreciation =
7000 – 260 = 6740
Amount to be shown in the liabilities side of balance sheet under Investment Fluctuations Reserves = = =
Total provision – Actual provisioning requirement 300 – 260 40.
17 Answer : (b) . Reason :When output increases above full-employment output, wages and prices will eventually rise. Rising prices cause money demand to increase, which causes interest rates to increase, crowding out investment.
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18 Answer : (c) . Reason :If the interest rates decrease, the decrease in the interest income is less than the decrease interest expenditure when the maturity gap is negative.
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19 Answer : (d) . Reason :When duration gap is negative, if interest rates decrease the market value of equity increases is false.
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20 Answer : (b) . Reason :If the investor buys and holds the 182-day T-Bill and sells the same after 91 days, the expected selling price will be Rs.98.30 (this is the same as the current price of the 91-day T-Bill because it is assumed that the yield curve is not changing in this period). Therefore the expected per annum return of the investor = (98.30 – 96.80)/96.80 x 365/91 = 6.22%. Hence (b) is the correct answer.
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21 Answer : (a) . Reason :Following is the process adopted by banks to value permanent
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10
investments: • Permanent investments should be valued at cost •
In case the cost price is higher than the face value, the difference should be amortized over the remaining period of maturity of the security • In case the cost price is lower than the face value, the difference should be ignored and should not be amortized or taken to income account as this represents unrealized gain. Hence (a) is the only true statement and is the correct answer. (d)
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23 Answer : (e) . Reason : Semi-implicit pricing refers to very low interest on current accounts, pricing below cost.
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22 Answer : . (PBT / TA) (NPA / TA) Reason :ENPA = PBT =
0.08 750 80 crore 1 0.25
(80 / 750)
ENPA =
a. b. c. d.
6% = 177.77%
Implicit pricing refers to no interest on current accounts and no cheque charges Rebate strategy refers to the bank makes charges but rebates on the basis of balance Symmetric account pricing refers to paying interest as function of minimal or average balance Explicit pricing refers to the collection of charge as the costs go and competition permits.
24 Answer : . Reason :Suppose loan amount = Rs.100 Interest earned = Rs.14 Part of the loan financed through capital = Rs.15 Interest on capital = 15 x 0.12 = 1.80 Return from loan = 14 – 1.8 = 12.2%.
(d)
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25 Answer : . Reason :Let, x = purchase price
(e)
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26 Answer : (a) . Reason : (a) Take out financing is an arrangement where the Institution/Bank financing, the
< TO P>
100 x 365 x x 91
= 0.0425
or, x = 98.95.
infrastructure projects will have an arrangement with any financial institution for transferring to the latter outstandings in respect of such financing on a predetermined basis. (b) In cash flow financing, the lenders finance the projects by estimating the cash flows of a project over its life time to see what kind of debt burdens it can support and at what rates. (c) Narrow banking means a bank which invests in government securities only. (d) The process of pooling and repackaging of homogeneous illiquid loans in to marketable securities and issuing to the investors through the capital markets is called securitization. 11
(e) An arrangement among the bankers to finance a borrower using a common loan documentation is called syndicated credit. Correct answer is (a). 27 Answer : (a) . Reason :NDTL =
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Liability to others + NIBL
Negative figure NIBL is not to be considered. Hence, NDTL = 4500 + (400 – 800) = Rs.4500 crore. 28 Answer : (a) . Reason :Efficiency Ratio is defined as Non-Interest Expenses / Net Total Income. Hence (a) is the correct answer.
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29 Answer : . Reason :Process is relevant to service sector like banking.
(b)
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30 Answer : . Reason :Statements in a, b, c, and d are true. Statement in option (e) is false.
(e)
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12
Section B : Problems 1.
a. Assets Amount Rate Cash 1500 0 Balance with banks and 840 0 Money at call & short notice 560 4 Investment – SLR 6300 6 – Others 2100 8 Advances – Agriculture 1395 9 – Export credit 465 8 – SSI 1860 10 – Housing 2325 11 – Others 3255 12 Total Liabilities Deposits : Savings Bank Demand Deposits Term Deposits
Borrowings
Amount 3740 2244 3366 3740 5610 180 120
Income – –
22.40 378.00 168.00 125.55 37.20 186.00 255.75 390.60 1563.50 Rate 3.5 – 5.00 5.50 6.00 7.00 8.00
Income 130.90 – 168.30 205.70 336.60 12.60 9.60 863.70 Spread
Total Interest Income – Interest expenditure = 1563.50 – 863.70 = 699.80 Spread Percentage = 699.80/21200 = 3.30% Let the interest rate on the subordinate debt be P% Total advances now = 9,300 + 450 = 9,750 Advances under export Credit = 465 + 450 = 915. New interest income = 1563.50 – 37.20 + 915 x 0.08 = 1599.50 crore New interest expense = 863.70 + 450 x P% Spread = 1599.50 – 863.70 – 450P = 3.30% of (21200+450) = 714.45 As same spread is to be maintained. Therefore P = 4.74% b.
New interest income = 1599.50 crore 13
=
c.
d.
New interest expense = 863.70 + 4.74% of 450 = 885.03 crore Hence, NII after the deployment of Rs.450 cr. = 1599.50 – 885.03 = 714.47 crore NII = 714.47 / 21650 = 3.30%. As per the expectations theory, (1 + r2)^2 = (1 + r1) (1 + f1) Where r2 = rate for a two year loan r1 = rate for a one year loan And f1 = implicit forward rate for one year, one year Hence, (1.10)^2 = (1.09) (1 + f1) implies that (1 + f1) = 1. 11009 implies that f1 = 1.11009 – 1 = 0.11009 = 11.01%. As per pure expectations theory, one year rate one year from hence will be 11.01%. In the current falling interest scenario, it is very much unlikely that a one year loan will cost more than what is today that is 9%. As per logical estimation one year hence at best, if there is no further interest rate fall in the economy, the rate won’t be more than 9%. If there is a fall it may even go below 9% which is the current trend. Here in lies the logical fallacy in the forward rate computed as per the pure expectations theory. In other words, expectations theory works fine in a rising interest rate scenario, but in a falling interest rate scenario, pure expectations theory really does not work. < TOP >
2.
NDTL = Rs.18,800 crore CRR requirement = 5% of NDTL = 940 Minimum CRR to be maintained on daily basis = 70% of 940 = Rs.658 crore So on the first day the bank has to borrow = 658 – 550 = Rs.108 crore for the 14 days On the 12th day, the bank’s owned funds would drop to 500, so the bank has to borrow = 658 – 108 – 500 = Rs.50 crore for the last three days Day
Owned Amount CRR funds borrowed maintained st th 1 day to 6 day 550 108 658 th th 7 day to 11 day 600 108 708 th th 12 day to 14 day 500 158 658 Total CRR requirement for the fortnight on the product basis = 940 x 14 = Rs.13,160 crore 14
Cumulative CRR 3948 7488 9462
Additional amount to be borrowed for one day to meet the total CRR Requirement = 13,160 – 9,462 = Rs.3698 crore Borrowing schedule I. Rs. 108 cr. on the first day for 14 days II. Rs. 50 cr. on the 12th day for the last 3 days III. Rs.3,698 cr. for 1 day during the initial period of the fortnight. Justification: It is a common practice in the call money market, that call rates soar high before the reporting friday as banks have to meet the reserve requirements to avoid penalties. Banks which are short of cash for maintaining CRR, borrow the amount from call money market. As the demand for funds increases, the interest rate also increases abnormally. Hence it is better to borrow larger amounts during the initial period of the fortnight. b. Day
Amount borrowed Rs.in crore 3,698
Number of Days
Interest rate per day
1
0.01096%
14 3
0.01096% 0.013698%
Any day in beginning 1st day 108 th 12 day 50 Total Total interest outgo in Rs.59,15500.
Interest outgo Rs. in crore. 0.40530 0.16570 0.02055 0.59155 < TOP >
3.
a.
Duration of Assets (DA) =
1400 2400 4500 5400 4300 1 3.5 3 1 18000 18000 18000 18000 18000
0
= 2.147 Duration of Liabilities (DL) = 1.669 b.
3800 3300 4200 4800 800 0.5 1 2 3 0.25 16900 16900 16900 = 16900 16900
Duration of surplus (DS) = DL +
A S
(DA – DL)
18000 (2.147 1.669) 1100
c.
= 1.669 + = 9.491 The duration of surplus is 9.491 which is positive. This indicates that there will be a definite impact on the value of equity with any change in interest rates. Computation of the change in the market value of assets, liabilities and equity value due to an increase in interest rate by 1% Change in value of asset / liability = D Changein int erestrate Currentmarket value (1 r)
Change in value of firm = Change in market value of assets – Change in market value of liabilities New market value = Current market value + change in the market value 15
Cost of deposits : (3800 × 0.035 + 3300 × 0.05 + 4200 × 0.055 + 4000 × 0.06 + 800 × 0.07) / 16900 = 873 / 16900 = 5.17% Yield on assets = (2400 × 0.06 + 4500 × 0.08 + 5400 ×0.10 + 4300 × 0.12) / 18000 = 1560 / 18000 = 8.67% Change in asset value
2.147 0.01 18000 1 0.0867 =
= – 355.63 New value of assets = 18000 – 355.63 = Rs.17644.37 crore 1.669 0.01 16900 1 0.0517 Change in liabilities =
d.
= – 268.20 New value of liabilities = 16900 – 268.20 = Rs.16,631.80 crore New value of the firm = New value of assets – New value of liabilities = Rs.1012. 57 crores ∴ Change in value of firm = 1012.57 – 1100 = – 87.43 To immunize the value of the firm, the duration of assets can be changed, in order to get the immunizing Asset Duration (DAZ) Immunizing Asset Duration (DAZ) = DL × = 1.669 × = 1.567 Change in asset value
L A
16900 18000
1.567 0.01 18000 1 0.0867
= – 259.56 New value of assets = 18000 – 259.56 = 17740.44 New value of liabilities = 16631.80 New value of the firm = 17740.44 – 16631.80 = 1108.64 The excess immunization has occurred due to different rates on deposits and assets. < TOP >
4.
It can be observed from the balance sheet that the bank is a deposit rich bank since nearly 82% of its working funds are mobilized by way of deposits. For a deposit rich bank, asset management will be suitable method to finance the loan proposal. Thus Future Bank Ltd. can disinvest some of its investments in securities or money at call and short notice to raise the necessary funds. a.
Cash balances of Fortune Bank Ltd
= Cash on hand + Bank balances in current 16
account = 90 + 90 = 180
b.
c.
Total working funds = 9,850 Average Cash balances maintained as a percentage of working funds = 180 / 9850 = 1.83% Variance allowed for cash and bank balances (5%) = 0.05 × 180 = + Rs.9.00 crore. Tolerance range for cash and bank balances = Rs.171 – 189 crore Thus the cash and bank balances for the bank should be maintained within this range in order to ensure adequate liquidity. Rise in deposit level by 10% = (1125 + 1875 + 5150) × 0.10 = 815 Thus total working funds = 9850 + 815 = Rs. 10665 crore Cash and bank balances to be maintained based on the increase in the working funds = 10,665 × 1.83% = Rs.195.17 crore. The tolerance range for cash and bank balances with the new level of working funds = Rs.185.41 – 204.93 crore The actual level of cash and bank balances falls slightly below the tolerance level. Hence the bank should ensure that the cash and bank balances do not remain at that level for a long period since it may cause liquidity problem. < TOP >
5.
Interest on Deposit: 2780 × 0.035 + 1880 × 0.045 + 1220 × 0.05 + 3450 × 0.055 + 4270 × 0.04 + 66.25 =
Rs.669.70 lacs
Interest on advances: 3650 × 0.11 + 240 × 0.08 + 5450 × 0.075 + 1590 × 0.13 + 4170 × 0.08 + 220.50 = Rs.1590.25 lacs Non interest expenses paid during the year : =
77 + 9 + 14 + 40 + 5 + 62 + 28 + 32 + 42 + 128 – 0.90
=
Rs.436.10 lacs
Other income: 0.10% of (6960 + 11080 + 18 + 1040 + 2060) + 4.80 =
21.16 + 4.80
=
Rs25.96 lacs
Interest receivable form HO Interest payable to HO
=
1.08 (669.70) + 21.50
=
Rs.744.78 lacs
=
1590.25 (1 – 0.25) + 6.90
=
1192.69 + 6.90
=
Rs.1199.59 17
Operating Result (Rs. in lacs) Interest received on advances Other income Total income (A) Interest paid on deposits Non-interest expenses Total expenses (B) Operating profit (A – B) H.O. interest receivable H.O. interest payable Net H.O interest payable (C) Ultimate profit (A – B – C)
1590.25 25.96 1616.21 669.70 436.10 1105.80 510.41 744.78 1199.59 454.81 55.60
< TOP >
Section C: Applied Theory 6.
Securitization” is a concept that has been around for some time but has only recently been taken up as a technique that could apply to a wide range of financial assets. The idea is to take fixed long-term loans and turn them into paper that can be readily bought and sold in the bond market. Assets securitized to date include: residential mortgages, trade receivables, retail auto loans, bank cards and equipment loans and leases, unsecured consumer loans etc.
Securities and Exchange Commission of the United States defines securitization as “the creation of securities that are primarily serviced by the cash flows of a discrete pool of receivables or other assets, either fixed or revolving that by their terms convert into cash within a finite time period plus any rights or other assets designed to assure the servicing or timely distribution of proceeds to the security holder”. Salient benefits of securitization Diversification of funding source and access to capital markets When structured correctly, obligations backed by receivables are not aggregated with the general credit or market risk of the originating entity. The resulting securities are therefore, likely to be rated higher than the credit rating of the seller’. Consequently, the originator can often access new markets and new investors which would not be otherwise available and not tie up traditional lending lines. Decreased funding costs and optimal usage of capital Even though up-front costs for securitization transactions can be expensive, such costs can be amortized over the life of a deal. Ultimate funding sources also tend to be more aggressive than those normally attainable by the originator. As a result, the all-in cost of funding to the Originator is likely to be lower than traditional sources. Enhancement of originator income A true securitization will remove assets from the balance sheet of the originator but, at the same time, will ensure the excess yield of those receivables retained. Depending on the relevant accounting standards of each jurisdiction, excess income may be taken up-front or over the life of the deal. Therefore, in effect, the Originator can increase operational gearing, support a larger asset base than before the transaction without increasing capital and at the same time, still benefit from the excess yield of the relevant portfolio. Enhancement of asset/liability management One of the most beneficial attractions to securitization is that as the securities are reliant on the receivables to pay down principal and cover interest, the funding is perfectly matched. In less 18
developed markets, long-term funding is often scarce resulting in a mismatch between long– and medium-term assets and short-term funding. Securitization can ultimately allow an Originator to write more business than it might otherwise do. Securitization can encourage a better business practice The steps and analysis involved in completing a securitization transaction can be complex and extremely detailed. Originators may have to update systems, and often the required historical analysis of assets and the in-depth detail on performance carried out by third parties can reveal information on the generation and management of portfolios that previously the Originator may not have been aware of. The potential pitfalls and caveats to securitization Disruption of existing funding One pitfall to securitization can often be caused by current funding arrangements. It is common for standard funding arrangements to have pre-arranged non-disposal covenants and negative pledge clauses attached. This does not necessarily preclude securitization, as the benefits can often outweigh the negative aspects for a lender. But in exceptional circumstances, lender may not be wiling to accommodate a transaction. Insufficient portfolio size As mentioned above, the upfront costs and on-going administration fees can be prohibitively expensive on transactions that are very small or have average lives. Portfolio of insufficient quality and homogeneity Securitization is mot effective when an Originator has a large pool of similar assets. Should the assets be too diverse in nature, it will become difficult to assess the unified performance of portfolio. This will mean that a lender or investor is less certain of the performance and it will usually result in higher credit enhancement requirements. Bad assets do not necessarily preclude securitization, but discounts and credit enhancement are needed to compensate and tend to make transactions inefficient. Inadequate systems and historical information The final and most practical of hindrances to securitization come in the form of an Originator not having the capability to monitor and manipulate assets and to provide sufficient performance data on a portfolio. < TOP >
7.
Once the bank is exposed to the interest rate risk, the immediate step to be followed is the quantification of the same by means of a suitable methodology. Some of the approaches used to tackle interest rate risk are discussed below:
Maturity Gap method: The objective of this method is to stabilize/improve the net interest income in the shortrun over discreet periods of time called the gap periods. The first step is thus to select the gap period which can be anywhere between a month to a year. Having chosen the same all the RSAs (Rate sensitive Assets) and RSLs (Rate Sensitive Liabilities) are grouped into ‘maturity buckets’ based on the maturity and the time until the first possible repricing due to change in the interest rates. The gap is then calculated by considering the difference between the absolute values of the RSAs and the RSLs, which is mathematically expressed as: RSG = RSAs – RSLs. RSAs RSLs
Gap ratio = where RSG = Rate Sensitive Gap based on maturity. The gap so analyzed can be used to cut down the interest exposure in two ways. The bank can maintain/improve its net interest income for changing interest rates, otherwise adopt a speculative strategy where in by altering the gap effectively depending on the interest rate forecasts net interest income can be improved. In either way the basic assumption of this model is that there will be an equal change in interest rates for all assets and liabilities. 19
During a selected gap period, the RSG will be positive when the RSAs are more than the RSLs, negative when the RSLs are in excess of the RSAs and zero when RSAs and RSLs are equal. Based on these outcomes, the maturity gap method suggests various positions that the treasurer can take in order to tackle with the rising / falling interest rate structures. Rate Adjusted Gap The Maturity Gap approach assumes a uniform change in the interest rates or assets and liabilities. In reality, however, It may not be the case basically due to two main reasons. Firstly, the market perception towards the change in the interest rate may be different from the actual rise/fall in the interest rates. For instance, if the bank rate is cut by I percent, according to the gap method, there will be a I percent fall in the rate of interest for both assets and liabilities. However, this may not be the case if the market perception for the decline in the interest rate is short-term in nature. This might eventually lead to a fall in the interest rate by less than I percent. Alternatively, the market may also perceive the rate fluctuations differently for the long-term interest rates and the short-term interest rates. For instance, rate fluctuation may lead to a 0.75 percent fall in the short-term interest rates while the long-term rates may witness a mere decrease by 0.25 percent. The second reason for differential rise/fall in interest rates of assets/liabilities can be the presence of a certain regulation. To explain this further, consider the differential interest rate loan extended by banks which has an interest rate of 4 percent. This rate remains constant irrespective of any amount of fluctuation in the interest rate of the bank. Similarly, it is quite common to find that the interest rates on term deposits rise/fall with changes in interest rates though the same does not affect the interest paid on savings bank. Having done away with the assumption of a uniform change in interest rates of assets/liabilities, the Rate Adjusted Gap methodology seems to be superior to the Maturity Gap methodology. In this approach, all the rate sensitive assets and liabilities will be adjusted by assigning weights based on the estimated change in the rate for the different assets/liabilities for a given change in interest rates. Rate Adjusted Gap = [RSA1 x WA1 + RSA2 x WA2 + ….] – [RSL1 x WL1 + RSL2 x WL2 + …..] ……… Eq. (2.6) Where WA1, WA2 = Weights of the corresponding RSAs WL1, WL2 = Weights of the corresponding RSLs Duration Analysis One of the limitation of the Maturity Gap approach is that it ignores the time value of money for the cash flows while determining the gap. Attending to this limitation of the Maturity Gap approach is the Duration Gap method. Duration Analysis concentrates on the price risk and the reinvestment risk while managing the interest rate exposure. While managing these two risks, Duration Analysis studies the affect of rate fluctuation on the market value of the assets and liabilities and net interest margins (NIM), with the help of duration. As seen earlier, the concept of duration helps in immunizing the interest rate risk by holding an investment till the end of duration instead of maturity. Having determined the duration, the affect of rate fluctuation on the NIM and the market value of the assets/liabilities of a bank can be assessed further by computing the Duration Gap for the portfolio of its assets and liabilities. In the first case, to monitor the impact of rate fluctuation on NIM using duration, the method followed is similar to the one used in maturity gap approach. However, the Rate Sensitive Gap calculated in Duration Analysis is based on the duration and not the maturity of the assets and liabilities. 20
Hedging Yet another means of managing the interest rate risk is by hedging with the use of derivative securities, viz. swaps, futures and options. This approach seems to be a better alternative, especially in a situation where there is a maturity mismatch. For instance, when liabilities are mostly short-term in nature and assets are long-term, the easier method of financing the assets, rather than trying to match the maturing periods is by the use of derivative securities. In a situation where there is an unexpected change in the interest rate structure or when interest rate forecasting becomes a difficult task, hedging proves to be an effective method to manage the interest rate risk. However, there are certain prerequisites for the effective utilization of the hedging instruments and their relating operations. First and foremost is the existence of a market that is deep and highly liquid. This again requires a proper benchmark for the interest rates and also an active floating rate market. In addition to this, a proper understanding of the hedging mechanism is a must for the effective usage of the derivative instruments, lest it may lead to an overall increase in the risk. Sensitivity Analysis The sensitivity of an asset/liability can be assessed by the quantum of increase / decrease in the value of the assets / liabilities of varying maturities due to the interest rate fluctuations. Based on the sensitivity, all the assets/liabilities are regrouped. The sensitivity model then suggests the assessment of the gap between the assets and liabilities having a similar sensitivity index to the interest rate fluctuations. Further action will be taken to manage the gap so as to restrict the interest-rate risk. Simulation and Game Theory Given the expected changes in the short and the long term operative environment, Game Theory simulates and forecasts the future trends. Using this concept, the expected risks and. rewards of the different asset and liability classes are given along with the risk sensitivity and the gap between the short, medium and long-term assets and liabilities. Then, simulation is done by varying the interest rate structures to predict the short/medium/long-term implications of the same. < TOP > < TOP OF THE DOCUMENT >
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